Can Diamonds Survive A Free Market?

August 6, 2009

Despite its celebrated slogan “Diamonds Are
Forever, De Beers, which has dominated the
diamond business for over a century, is
discovering that diamond profits are not
forever. It reported in July that its profits for
the first half of 2009 fell by no less than 99%.
The problem is not that the mining giant is running out of diamonds. Its highly efficient
diamond mines in South Africa, Botswana and Namibia still supply about
40 percent of the world’s gem-sized diamonds. Nor have diamonds lost their
value. They not only remain a vital part of the engagement ritual but their retail
price of engagement rings has actually risen in 2009. What is killing De Beer’s
profits is the prohibitive cost of running a cartel. The cartel arrangement is
necessary to sustain the illusion that diamonds are rare.

Diamonds, to be sure, once were exceedingly rare. Then, in the late 19th
century, huge pipes full of diamond ore were discovered in South Africa, and the
diamond prices fell to less than one dollar a carat. Cecil Rhodes, who by 1890 had
consolidated almost all the pipe mines into his De Beers Company. wrote in a
letter that diamonds were on the verge of becoming a "frightful drug" on the
market unless production was restricted. To create the balance between world
supply and demand, Rhodes proposed that the annual production be limited to
roughly the number of "licit relationships," as he termed engagements, in the
United States., which was then the main market for diamonds. Ernest
Oppenheimer, who took over De Beers after Rhodes’ death, further perfected the
cartel by taking over the Diamond syndicate in London. This arm of the cartel,
run by Oppenheimer’s brother Otto, gave De Beers control over the global
distribution market and evolved into the innocuous- sounding “Central Selling
Organization,” The Oppenheimers used it to allocate the world’s rough diamonds
to diamond cutters in Antwerp, Tel Aviv, and other cutting centers according to its terms. If a cutter wanted to be part of the arrangement, he had to blindly accept all
the diamonds offered to him in a box by De Beers, and follow its rules. Ernest
Oppenheimer wrote: "the only way to increase the value of diamonds is to make
them scarce.” Working through an intricate system of bankers, shell
corporations, and buying agents, De Beers bought up diamonds
wherever they were found, acting as the buyer of last resort, and, if
necessary, adding them to its stockpile. When demand for diamonds
collapsed in the great depression, Oppenheimer closed all major mines, cutting
production from 2,242,000 carats in 1930 to 14,000 carats in 1933. His son Harry,
who succeeded him in 1957, continued this strategy, telling shareholders that De
Beers had no choice but to tightly control the global supply of diamonds because
"wide fluctuations in price, which have, rightly or wrongly, been accepted as
normal in the case of most raw materials, would be destructive of public
confidence in the case of a pure luxury such as gem diamonds, of which large
stocks are held in the form of jewelry by the general public." In other words, if
prices were allowed to go down, the diamonds-are-forever illusion would shatter,
and people would begin to sell their diamonds. Under his regime, when new
diamond mines were discovered any place in the world, De Beers negotiated
through one of its front companies to buy all those diamonds, even if it meant
locking them up in its vaults in London. No distinction was made between
friends and foes. At the height of the Cold War, when diamonds were
discovered in Siberia, De Beers arranged with the Soviet Union to take
its entire output. This deal required De Beers in the 1980s to buy from
the Soviet Union 2.6 million carats a year– nearly one-quarter of the
world's production– which provided Moscow with so much hard
currency that the head of the Russian Diamond Administration said, "We
call ourselves the country's foreign exchange department."

While this global cartel succeeded in sustaining the illusion of scarcity,
by the 1990s it began to put increasing financial strain on the
company’s finances. Ironically, what sealed the cartel’s fate was the
Oppenheimer family’s effort to tighten its iron grip on De Beers through
a leveraged buyout in 2004. Up until then, the Oppenheimers, who only
owned about 8 percent of De Beers relied on a maze of interlocking
companies to control it. After the buy-out, 40 percent of the company
was directly owned by Oppenheimer family’s holding company and 45%
was owned by the Anglo-American Corporation, in which the Oppemheimers were major share-holders. But to effect the buy-out De
Beers had borrowed over $ 4 billion from banks, who imposed
covenants that restricted its ability to borrow further to buy diamonds for
its stockpile. “Debt drove the deal, as it always does,” one shrewd
London banker observed. As a result, he added “The new De Beers is not
the old De Beers.”

When the recession collapsed demand for diamond in 2008, De Beers
could still shut down its mines– and in 2009 it reduced its production by 91%–
But, given its debt burden and covenants, it could not borrow to buy the growing
surplus of diamonds from other mines around the world. So it could not continue
the century-old cartel arrangement. The European Union, which had found
that De Beers had violated its anti-monopoly rules by stockpiling
Russian diamonds, provided a convenient fig leaf for its exit strategy .
Instead of renewing its deal to buy Russia’s rough diamonds in 2009,
De Beers handed over the job of stockpiling surplus diamonds to the
Russian-government backed diamond monopoly, Alrosa. For Alrosa to
support prices, it not only had to stockpile the enormous production from
the Siberian mines but after new pipe mines had been discovered in
Angola, it had to negotiate a De Beers-style arrangement with the
Angolan government to buy up its diamonds. “If you don’t support the
price,” Andrei V. Polyakov, an Alrosa official told the New York Times,
“a diamond becomes a mere piece of carbon,” while a top Alrosa
strategist said, “We have to tell people that diamonds are valuable...We are
trying to maintain the price, just as De Beers did, But what we are doing is selling
an illusion.”

But even if the Russians fully understood the requisites of the cartel,
they faced an almost intractable problem in the form of $5 to $7 billion
worth of diamonds that were already in the “pipeline” that extended
from the cutters and jewelry manufacturers to the wholesalers.. With the
dearth of retail sales in 2008, these diamonds could only be contained in
the pipe line for a limited time before the banks who had financed their
purchase in 2007-8 at the height of the bubble, took action to get repaid,
which would cause fire sales at the wholesale level. Alrosa has not as yet
intervened to absorb these diamonds, and it may not have the resources
to do so. According to a major diamond dealer affiliated with De Beers
“Alrosa is not De Beers. It doesn’t have the network of connections with dealers and financiers, or experience, to control the pipe line.” If so, diamond prices could go into a free fall, and finally test Harry
Oppenheimer theory that the diamond illusion cannot survive the
destructive price swings of a free market.